Critically analyze the transmission mechanisms that provide the link between monetary policy and Gross Domestic Product (GDP)

Topics: Monetary policy, Inflation, Central bank Pages: 6 (1870 words) Published: March 8, 2014

Critically analyze the transmission mechanisms that provide the link between monetary policy and Gross Domestic Product (GDP)

Financial globalization in recent years has affected the monetary transmission mechanism, either by changing the overall impact of policy or by altering the transmission channels.The liberalization of capital accounts alongside technological advances and the emergence of increasingly sophisticated financial products have posed new macroeconomic challenges for central banks in industrial and emerging market economies. As a result understanding the transmission mechanism of monetary policy has become one of the pressing issues for policymakers and researchers in recent years. The monetary transmission mechanism refers to the process through which changes in monetary policy instruments affect the rest of the economy and, in particular, output and inflation.Monetary policy is transmitted through various channels that affect different variables and markets in different speeds and magnitude. Key financial variables such as interest rates,asset prices, credit, exchange rates and monetary aggregates define the six transmission channels-the Interest Rate Channel,the Bank Lending Channel,the Balance Sheet Channel,the Equity Price Channel,the Exchange Rate Channel and the Expectations Channel.These channels are interdependent and interrelated as the effects of monetary policy actions could flow through various paths and influence the inflation and Gross Domestic Product in various ways.

Empirical evidence has shown that the interest rate channel is the most important transmission channel in industrial countries with developed financial markets. An increase in the short-term nominal interest rates will lead to higher real interest rates given the assumption of sticky prices. Higher real interest rates will affect both investment and spending and lower current spending. However, the increase in real interest rates will lead to an increase in savings. The profits of the firms will decrease making investments less attractive. As a result from this mechanisms the decrease in investment and consumption will lead to a contraction in output thus pulling prices down .As wages/goods prices adjust overtime ,real Gross Domestic Product will return to its potential level and so will the real interest rate( Schmidt-Hebbel, 2002). For the United Kingdom, a temporary increase of interest rates by 100 basis points lowers output by around 0.2-0.35 per cent and inflation by 20-40 basis points after about a year (Bank of England, 1999).This channel depends deeply on the pass-through effect of monetary changes on consumption. There could be asymmetric effects on the wealth-consumption channel .This means the central bank should take into account the fact that increasing the interest rate will not reign in consumption growth to the desired level which makes it very important to rethink monetary policy measures. The Interest Rate Pass-through suggests that the interest rates of banks are reacting slow to monetary policies and also there is no uniform pattern in the pass-through between loans and deposits. Many economists have questioned the effectiveness of the Real Interest Rate Channel. Bernanke and Gertler (1995) claimed that only short-term interest rates are influenced by monetary policy innovations, while these are long-term rates that to a large extent affect durable assets purchase, therefore, monetary policy transmission through the interest channel proves to be ineffective.(Bernanke and Gertler ,1995).On the other hand, Smets and Wouters (2002) concluded that in countries of the euro area the interest rate channel proved to be effective in transmitting monetary impulses on consumption and investment demand and, consequently, on real output(Smets and Wouters ,2002).Even though there is no clear proof whether this is the best transmission...

Bibliography: MISHKIN, Frederic S., 2010. The economics of money, banking, and financial markets. Pearson.
HANDA, Jagdish., 2000
Fernando Barran & Virginie Coudert & Benoit Mojon, 1996
The transmission of Monetary Policy in the European Countries
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